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Pledge Of Shares
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In times when the Indian Stock Market is experiencing never seen before volatility as a consequence of COVID-19, it is necessary to understand a not-so-discussed topic about investing in the market. This topic is the Pledge of Shares.
While writing this article, data on dropping GDPs from across the world are getting reported. Almost every country under the effects of the deadly virus has got a taste of sharp falls.
From the European countries to the United States of America, India, Brazil, Japan, every major economy has been affected badly. China is the only exception to this shift.
You must be wondering why weāre discussing the state of economies across the world.
Thatās because the volatility of Stock Markets across the globe has shot up. Further, the process of pledging of shares has heightened due to the lower liquidity rate of shares in the stock market.
To understand this confusing but straightforward process, read along.
The first question necessarily answered about this topic is – What is the Pledge of shares?
Pledge of shares is a process of mortgaging some part of the shares held by promoters and investors in exchange for money required for capital investments, daily company functions, or personal use.
Generally, a companyās significant shareholders pledge a certain percentage of the shares to meet their personal or professional requirements.
Although the shares go to the lenders in the paper, the shareholders retain the ownership. This act gives them the authority to be still a significant shareholder and the positive reinforcement to pay back the lender.
Retaining ownership not only motivates the shareholders but also keeps the prices of the shares in the Stock Market stable and avoids sudden panic among the investors or retail traders.
This panic might lead to a downfall in the share prices, heightening the troubles for these shareholders.
The promoters can always avail of this choice to pledge shares to fight off any financial crisis.
The promoters carry out the procedure of the Pledge of Shares. Still, from various instances of the past, it is a repetitive occurrence that these actions have direct implications for retail traders.
How?
When the Pledge of shares occurs, the market risk of respective shares increases. If shareholders default on the loan, it will lead to volatile movements of the stock prices.Ā
This situation would be favourable for neither of them, the promoters, or the investors. The scenarios might get very messy and unpleasant for the retail traders.
Before talking about this in detail, you need to understand what a listed company is.Ā Companies that list their shares on any official stock exchange for trading are known as Listed Companies.
These companies must adhere to the requirements set by the respective stock exchange and SEBI (Securities and Exchange Board of India).
These requirements range from how many shares a company can list to a minimum level of earnings.
These companies could hurt retail investors to extremes. But, to avoid such situations, every exchange discloses the percentage of shares pledged on its website, by every company listed on it.
Thus, to avoid investing in such shares, keep an eye on the regular updates by the respective stock exchanges to know about India’s Pledge of shares.
The definition of an unlisted company is simple, considering you understood a listed company’s description in the previous section.
An unlisted company is the one that doesnāt get listed on any exchange and thus has no restrictions whatsoever. So, the price of the stocks gets decided by the investors of the company.Ā
Usually, in the case of unlisted companies, the Pledge of shares is not done. Thatās because no amount will be the correct market price or a minimum price.Ā
For instance, you are the lender, how will you determine the minimum price you wish to pay for each share pledged when you donāt know the market value.
But, on a case to case basis, some unlisted companies are permitted to pledge their shares. The procedure to be followed for this to happen is by passing a board resolution for the same. Further, it must be added in the Minutes Book by the company.
As discussed above, a board resolution needs to get passed for an unlisted company to carry out the Pledge of shares.
The different brokers set a proper board resolution format for uniformizing it for their customers’ Pledge of shares.
You can access this format from the DPās nearest branch office or download it from their website.
A regulatory change by RBI, in addition to its Circular 57, permits the non-resident shareholders of Indian Companies to pledge their shares for a loan. They can avail of these loans from both Indian or Overseas Banks both.
They have to submit a No-Objection Certificate (NOC) from the appropriate Authorized Dealers (AD), and they get permitted to pledge the shares. The mandatory guideline of getting approval from the RBI got done away with if the conditions laid down get fulfilled.
ADs regarding FDI, such as public sector banks, multinational banks, and private banks, can act as an Authorized Dealer in the matters relating to the Pledge of shares.
The procedure for the Pledge of shares is laid down by Regulation 58 of SEBI (Depositories & Participants) Regulation, 1996.
The manner for creating a pledge of shares is as follows
- Pledgor initiates the procedure by filling and submitting a duly filled Pledge Request Form (PRF) to his Depository Participant (DP).
- All the Demat joint account holders must sign the PRF, mandatorily.
- The Pledge Request Form can be countersigned by the lender.
- After the PRF is received, pledgorās DP verifies the proposal to pledge the securities. Encumbrance and free balance get checked thoroughly.
- In the depository system of the DP, a pledge gets set up by the respective DP. This entry generates a unique Pledge Sequence Number.
- The Pledgee receives an acknowledged copy of the PRF.
- The depository participant of the Pledgee accesses the request to pledge shares online.
- The DP takes a call on the requestās acceptance or rejection based on the Pledgeeās PRF copy. The DP selects the accept flag or the reject flag accordingly.
In an agreement for the Pledge of shares, it gets signed by three parties, namely
- Lender
- Promoter
- Borrower
The agreementās main signees are the lender (bank or NBFC) and the borrower (usually the company). Further, a collateral contract between the promoter and the company borrowing money is signed.Ā
After the borrower shows a green flag for the pledges of shares agreement, the security agreement comes into force. Primarily, when a promoter is in talks with the loan lender, he/she carries out this on the companyās behalf or as an agent but does so in his capacity.
Some crucial points for the Pledgee in the Agreement for Pledges of Shares are
- The lenders obtain the right to attend any meeting of the company or with any of the creditors. They have permission to exercise their voting rights for the pledged shares.
- Board resolutions and corporate approvals are mandatory for pledging shares.
- No preceding lending should be active on the pledged shares.
- There should be no other charges or encumbrances pending on the shares pledged.
- The respective company must get listed on an official exchange in India. Moreover, the shares said should be freely traded on that exchange.
- The companyās articles should approve of share pledging.
- No additional pledge, right, encumbrance or transfer can get processed on the shares once pledged to a lender.
- The pledgor canāt be a party to any agreement restricting the transfer of pledged shares.
- If the pledgor defaults on the loan, the lender can acquire or sell the pledged shares as the lender considers reasonable.
- When pledges of shares occur, it is necessary to include the pledging charges in the charges register. Further, the documents with the pieces of evidence of pledging should be submitted to the concerned Registrar of Companies as mandated in the Companies Act, 1956.
- Irrespective of the company’s position in the future, i.e., merger, reconstruction, the takeover of management, nationalization, or any other events, the security according to the Pledge of shares remains the same till paid.
Some necessary points to keep in mind for the Borrower or Pledgor
- When the obligations, on the part of the borrower, are met, the agreement stands terminated.
- As soon as the agreement terminates, it becomes an obligation on the lender to release the pledged shares and deposits against the credit to the borrowerās designated account. Also, the lender should send a new power of attorney marked as cancelled to the pledgor.
- No party gets permission to make an amendment or changes to the agreement.
When a promoter carries out the Pledge of shares, the shares are collateral or security against the loan they receive for the pledged shares. Irrespective of who owns the shares, i.e., promoter or investor, they get pledged for meeting expenses in oneās personal or professional capacity.
Before implementing the Depository Act, 1996, the Pledge of shares was on physical shares. But with the introduction of Dematerialised or Demat accounts, the process got shifted to Demat shares majorly. If you don’t know what we are talking about, then you would need to understand the Dematerialisation meaning.
Some things to take a note of, while pledging shares, are:
- Both Pledgor and Pledgee must have a Depository Account. Here opening Demat account with depository is however not possible, but you can choose the stockbroker registered with either or both of them.Ā
- The borrower and lender must have a Demat account registered with the same National Depository, i.e., CDSL or NSDL.
- The Depository Participant need not be the same.
- All the financial transactions get operated outside the depository system.
- Till the pledged shares get invocated, the borrower has all the corresponding rights over the corporate benefits.
Pledge Of Shares In Physical Form
Holding shares in physical form was prevalent before the implementation of the Depository Act, 1996. However, after the said act got introduced, physical shares decreased in numbers due to dematerialization over time.Ā
Still, many shareholders held onto the physical shares. Thus Securities and Exchanges Board of India (SEBI), in a press release in 2018, announced that after 31 March 2019, only dematerialized shares will be bought or sold.
Physical shares would, technically, become illiquid. Illiquid means you can neither buy/sell them nor transfer them.Ā
So, physical shares no more exist to be pledged, and if they do, they can’t undergo pledging.
Since the stock market volatility is very high, the price of the Pledge of shares might fall below the margin level at some point in time. At this very moment, is when a feature called ‘Margin Call‘ enters the picture.
The margin level is the lowest price the lender agrees to hold the shares if the market price drops. It is a price agreed upon by both parties while they sign the agreement for the Pledge of shares.Ā
When this feature gets triggered, the lender asks the borrower to deposit extra cash or more securities as additional collateral, or the lender sells the pledged shares to settle the loan.
However, forced selling of the Pledge of shares might lead to a vicious cycle of its shares selling beyond limits.
This cycle might hurt the retail investors horribly, as the sudden fall in the prices will cause huge losses.
When a promoter does pledges of shares, there is a chance that they might end up being excessively leveraged and, thus, default on the loans. Once the pledgor defaults, the lender can invocate the shares.
The invocation of the pledged shares means the lender sells the shares in the open market to recover the money lent to the promoters. This action, based on past experiences, results in knee jerk reactions or negative impacts.
One of the significant adverse impacts is a steep decline in stock prices and a panicked state for retail investors. Since the pledged shares are chunks of large quantities, the lenders arenāt bothered with the sharesā falling prices while invoking them.
In this process of invocation of the Pledge of shares, the most significant loss bearers are public shareholders due to sudden and massive erosion in the share value.
SEBI (Securities and Exchange Board of India) notifies new regulations now and then. According to the latest guidelines issued, the points to pay attention to are as follows:
- When the combined encumbrance crosses 20 percent of its total shares capital, the promoters would have to disclose individual reasons.
- New norms for differential voting rights got cleared by the SEBI board. It allows firms, having a few shareholders with exclusive voting rights, to get listed.
- Differential Voting Rights (DVRs) got the regulatorās approval. Still, it is available for only non-registered new technology firms. The fields of technology included under this approval are IT, IPR, Data Analytics, Bio-Technology, or Nano-Technology.
- Superior rights shareholders should become an integral part of the promoter group of the company, with a collective net worth of fewer than 500 crores.
- Superior Shareholders must necessarily hold executive positions like promoters or founders.
- Technology startups got the most out of these norms with asset-light business models.
- The sectoral limit on liquid funds was reduced to 20 percent, which was initially 25 percent. This condition means that the company has to hold 20 percent of its assets as liquid assets such as cash and government securities.Ā
- Further, liquid funds can have an exposure to NBFCs and HFCs of an aggregate of 40 percent.
- Companies who wish to pay a royalty of more than 2 percent will require the shareholdersā nod. Any royalty payment more than 5 percent of the sales will get considered as material.
- Before filing for IPO, the shares, for at least six months, must be held. Also, there will be a sunset clause.
To know if the shares you are willing to buy are safe of the risks posed by the Pledge of shares, you need to follow these simple steps:
- Log on to the corresponding Stock Exchange website.
- Search for the scrip.
- Click on the āCompany Informationā option.
- Next, click on the āmarket trackerā button.
- Here, the latest shareholding pattern of the company is available for the traders to view. Everything about a companyās shares is open to view from the number of shares pledged or encumbered to the total shares.
Conclusion
Pledge of Shares is a simple process with profound implications if the after results are opposite to the plan.
Pledging your shares means mortgaging a percent of shares you hold for money, which might be for personal or professional use. A shareholder pledges his shares to gain capital for investments in the company or day-to-day functions or individual requirements.
The shareholder does this in his capacity and rightfully retains the ownership. The ownership gets retained only until the borrower doesnāt default on the loans. Once he enters the defaulterās list, the lender can take any action as he deems appropriate.
The Pledge of shares gets regulated by the respective Depository and the SEBI. SEBI permits the pledging of only dematerialized shares and listed companies.
For the unlisted companies, the procedure is usually not applicable, but the lender takes the final call.
You need to follow the simple steps listed earlier to initiate the process of pledging, and youāll be able to raise capital.
Moreover, the pledging of shares has high-risk implications for the retail investors of that company. In the worst-case scenario, when the pledged shares get sold in the open market, the prices might come down crashing.
This phenomenon is unprecedented and might affect retail investors in the worst way possible.
Once the total loan gets paid off, the Pledge of shares gets invocated and handed over to the shareholders.Ā
So, before investing in any share, make sure to go through the companyās pledge percentage on the stock exchange website.
Happy and safe investing, folks!
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